About the toxicity of the EFSF and the AAA ratings of France and Germany

2011-08-13

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In a previous analysis I explained how the toxicity of the European Financial Stability Facility (EFSF) is the source of contagion. In this article I shall expand this thought to incorporate the latest events on the political environment of Europe, as Italy and Spain the 3rd and 4th largest economies of the euro area, might be allowed (or forced due to market pressures) to opt out of the second bailout to Greece.

Meanwhile France might come to a very unpleasant situation of bailing out its “too big to fail” private banks that have a massive exposure to Southern European debt, at the cost of sacrificing its triple-A credit rating, which still allows for relatively cheap interest rates at the international markets. In this tide of events Germany will inevitably be affected thanks to the structure of the EFSF as it will come to the tough dilemma of either defending the euro or allowing it to meet its fate.

Before evaluating the above situation I first need to put you into context regarding the toxicity of the EFSF. Here is an extract from my analysis on the toxicity of the EFSF which is the source of contagion, which explains why this mechanism allows the crisis to spread and worsen:

The reason is simple. Hardly-pressed governments, whose economies are going through a serious recession and who have imposed austerity measures to reduce their spending are called to contribute to a common fund to bail out other countries. One country would be affordable but as time passes more and more countries join the club of the “fallen”, coming to the need of a bailout, thus making the burden even heavier for the rest. We currently see this in the plan that was decided on the July 21 EU summit, where countries that face serious problems in their economy, such as Cyprus, Spain and Italy are asked to pay a second bailout to Greece.</p>

So these hardly-pressed countries come to the point where they adopt strict austerity measures to put their finances under control at the expense of shrinking their economy and at the same time are called to increase their spending for the sake of saving another country. Hence austerity diminishes their economy and the EFSF further worsens their fiscal position. This means that interest rate spreads over government bonds will increase, since everyone in the market realizes the inviability of this cycle.

In such an unstable structure the contamination of the healthier parts is inevitable. That is why the “Greek” crisis, became “Irish” and then “Portuguese” and now it has seriously affected Italy, Spain and Cyprus, while France and Belgium are close behind.

If Italy and Spain opt out of funding a second Greek bailout, then all the weight will fall on France and Germany. Hence the burden for the two biggest economies of the euro area will increase considerably.

Given the tough position in which France is now found into and given the fact that President Sarkozy was forced to interrupt his vacations in order to call for an emergency meeting of his cabinet to decide on austerity measures, this extra burden will be tough to bear. Additionally this event alone is enough to seriously threaten the triple-A credit rating of the country (this will also happen if the government is forced to save French private banks).

It becomes clear that France is now standing on very slippery grounds. A slight imbalance caused either by exogenous factors, such as Italy and Spain opting out of the EFSF, or by endogenous factors, such as major private banks requiring bailouts due to a worsening in the situation of the countries where they are exposed, will lead France to a credit rating downgrade which will give new incentives to speculators to ask for greater premiums on government bonds (France will have to pay higher interest rates).

In simple words France is one step away from entering a vicious cycle and should that happen Germany will be caught in it as well, as then the burdens for saving the euro will all fall on the eurozone’s leading economy (because of the toxic structure of the EFSF). Hence Germany’s triple-A rating will also be put under threat if Chancellor Merkel undertakes that extra burdens (which I doubt she will).

George Soros, in his latest article says that “Germany must defend the euro”. A view that many like him share. This statement omits (or massively underestimates) the toxicity of the EFSF, since if Germany alone has to save the euro, then it will do so at the expense of its own economic viability. Germany alone cannot save the euro, both because it is practically impossible and because that would be an outrageous political choice that would probably create unrest in the already frustrated German electorate.

The toxicity of the EFSF is causing contagion and is compounding the problems. The vicious cycle in which France, Italy and Spain might all go into means that even the credit rating of Germany can be threatened by means of the EFSF. European leaders must fundamentally redesign the structure of the EFSF, before things reach the point of no return otherwise the above dynamics will shape a highly unpleasant situation. When that moment comes Germany will exit the euro and not save it as many want to believe.

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